INVESTMENT

AND PORTFOLIO
MANAGEMENT

CHAPTER 11:

An Introduction to Security
Valuation

Written Report

Submitted by:

Gilbertson R. Tinio, CPA

I. Introduction
The first two parts of Investment and Portfolio Management discussed about
the Investment Background and Developments in Investment Theory. Part three will
introduce valuation principles and practices that are useful in managing
investments or a portfolio of investments. After analyzing financial statements of
individual companies, we will incorporate in this chapter the economy and industry
where businesses operate.

But why do we need to incorporate such factors in our investment and

portfolio management and in what part of it do the incorporation of the economy
and industry in our analyses. Its essence can be realized answering the latter
question, saying so: Investment Decision Process. This process is very crucial to the
investment manager since it causes the events during its stewardship and it directly
impacts the investment and portfolio.

Part 3 introduces the two major approaches to the investment process and
this chapter will explain the specifics and logic of the top-down (three-step)
approach. This chapter also tackles the investment decision process and digs down
in different valuation techniques such as the valuation of bonds, preferred stocks
and common stocks using two primary approaches. These two approaches will be
tackled in detail discussing the available techniques that an individual can conduct,
the conditions to best use each approach, how to apply each approach and the
required inputs in applying each approach.

After detailing the concepts and applications of the two approaches, the discussion
will continue to the latter part of the investment decision process tackling the other
factors that must be considered in the decision making. At the end of this chapter,
you should be able to conclude what are the factors that an investment manager
must consider during the investment decision process by using the two major
approaches and decide whether a specific investment is good or bad.
II. Discussion
Two approaches in Investment Process
As introduced earlier, there are the two major approaches of the investment process,
namely: (1) Top-down, three-step approach and (2) Bottom-up, stock valuation,
stock picking approach. In order understand how it works, we must first identify
what are the three steps of the investment process. Exhibit 11.1 entitled “Overview
of Investment Process” of Reilly and Brown’s Investment and Portfolio Management
(referred to as “the Book”) summarizes the three step process.

This exhibit explains the following steps:

General Economic Influences: Many economic forces affect the investment decision
making since these forces generally affect all entities under it. Examples of this as
given in the Book are Monetary and fiscal policy measures, inflation and other
events such as war, political upheavals in foreign countries, or international
monetary devaluations.
Industry Influences: The next step is to identify industries that will prosper or suffer
in the long run or during the expected near-term economic environment. We must
consider the conditions that affect specific industries such as are strikes within a
major producing country, import or export quotas or taxes, a worldwide shortage or
an excess supply of a resource or product, or government-imposed regulations on an
industry.
Company Analysis: And for the last step, as discussed in the previous chapter
“Analysis of Financial Statements”, an investor should analyze and compare an
individual firm’s performance relative to the entire industry using financial ratios
and cash flow values. Discussion of such ratios and values will continue in the latter
part of this topic which will introduce the theory of valuation. Moreover, in order to
identify the best company in a promising industry, an investor should examine a
firm’s past performance and, more important, its future prospects.

This investment decision approach is consistent with the discussion in

Chapter 2 “The Asset Allocation Decision”, which contended that the most
important decision is the asset allocation decision. The asset allocation specifies:
1. what proportion of your portfolio will be invested in various nations’
economies;
2. within each country, how you will divide your assets among stocks, bonds, or
other assets, and;
3. your industry selections, based on which industries are expected to prosper
in the projected economic environment.

Investment Decision Process

This process involves two parts that are:
1. Estimate the intrinsic value of the investment at your required rate of return
2. Compare the estimated intrinsic value to the prevailing market price.
An investor should not buy an investment if its market price exceeds the estimated
value because the difference will prevent from receiving the required rate of return
on the investment. On the other hand, if the estimated intrinsic value of the
investment exceeds the market price, an investor should buy the investment.

This could be summarized as follows:

If Estimated Intrinsic Value > Market Price, Buy or Hold it if You Own It.
If Estimated Intrinsic Value < Market Price, Don’t Buy or Sell it if You Own It.
Theory of Valuation
This theory is used in the first step of the Investment Decision Process that is to
estimate the intrinsic value of an investment by using the available techniques which
will be discussed later. Valuation is the process of assignment of value to an asset by
calculating the present value of its expected returns. The calculation requires two
major components namely:
1. Cash flows (stream of expected returns) - has to consider:
a. Form of returns (Earnings, Cash flows, Dividends, Interest payments,
Capital gains or increases in value)
b. Time pattern and growth rate of returns
2. Discount rate (required rate of return) - as discussed in Chapter 1 “The
Investment Setting”, this can be determined by the following:
a. Economy’s risk-free real rate of return, plus
b. Expected rate of inflation during the holding period, plus
c. Risk premium determined by the uncertainty of returns

“Let’s start valuing!”

VALUATION
Valuation of Bonds:
Valuation of Bonds is relatively easy because the size and time pattern of cash flows
from the bond over its life are known. Important details are provided in detail in
each investment agreements and below are the usual required details in valuing
bonds:
1. Interest payments usually periodic so we must divide the applicable nominal
rate per period.
2. Payment of principal on the bond’s maturity date

For example*:
In 2018, a P100,000 bond due in 2023 with 10% coupon. Discount these payments at
the investor’s required rate of return (if the risk-free rate is 9% and the investor
requires a risk premium of 1%, then the required rate of return would be 10%)

(1) Present value of the interest payments is an annuity for thirty periods at one-half
the required rate of return and (2) the present value of the principal is similarly
discounted
(1) P5,000 x 15.3725 = P76,862.50
(2) P100,000 x 0.231375 = P23,137.50
Total value of bond at 10 percent = P10,000

*This example is aligned with the Book.

Valuation of Preferred Stock:
Owner of preferred stock receives a promise to pay a stated dividend, usually
quarterly, for perpetuity. Since payments are only made after the firm meets its
bond interest payments, there is more uncertainty of returns.

The value is simply the stated annual dividend divided by the required rate of
return on preferred stock (kp).
Dividend
V
kp

For example*:
Assume a preferred stock has a $100 par value and a dividend of $8 a year and a
required rate of return of 9 percent
$8
V  $88.89
.09
*This example is taken from the Book.

Valuation of Common Stock:

In valuing common stock, the approaches below have been developed:
1. Discounted cash-flow valuation - Present value of some measure of cash flow,
such as dividends, operating cash flow, and free cash flow
2. Relative valuation technique - Value estimated based on its price relative to
significant variables, such as earnings, cash flow, book value, or sales

These two approaches are both affected by:

1. Investor’s required rate of return, represented by ‘k’ - (kV)
2. Estimated growth rate of the variable used represented by ‘k’ - (gV )

Exhibit 11.2 below introduces the specific techniques under the two approaches:
Summary of the two approaches is below:
III. Summary and Conclusion
As per Reilly and Brown, we apply the valuation theory to a range of investments,
including bonds, preferred stock, and common stock. Because the valuation of
common stock is more complex and difficult, we suggest two alternative approaches
(the present value of cash flows and the relative valuation approach) and several
techniques for each of these approaches. Notably, these are not competitive
approaches, and we suggest that both approaches be used. Although we suggest
using several different valuation models, the investment decision rule is always the
same: If the estimated intrinsic value of the investment is greater than the market
price, you should buy the investment or hold it if you own it; if the estimated
intrinsic value of an investment is less than its market price, you should not invest in
it and if you own it, you should sell it. We conclude with a review of factors that you
need to consider when estimating the value of stock with either approach—your
required rate of return on an investment and the growth rate of earnings, cash flow,
and dividends. Finally, we consider some unique factors that affect the application
of these valuation models to foreign stocks.